Report
Michael Wong
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Morningstar | Goldman Sachs' Transformation Should Be Positive for Those With a Long-Term Investment Horizon

We're positive on the strategic changes that Goldman Sachs is undergoing, but we wouldn't be surprised if it takes two years for its efforts to be discernible. The company is in the middle of a "front-to-back" review of its business that aims to expand revenue on the front end, especially in newer business lines, and optimizing expenses and capital of traditional business lines on the back end. The current Goldman narrative reminds us a lot of Morgan Stanley after its Smith Barney merger, where the firm is on a trajectory of adding more stable, capital-light revenue streams, but the market isn't giving the company any credit for it. We think that the company's digital banking platform and increasing emphasis on wealth and asset management will increase returns on equity and that means that shares trading near tangible book value per share of $198.25 are attractive. We are maintaining our $257 fair value estimate for narrow-moat Goldman Sachs.

Given where we are in the capital markets cycle and the company's investment cycle, it could take a while for the company's initiatives to clearly show in the bottom line. Management sees 2019 and 2020 as investment years where the company's expense ratio may not show improvement from current initiatives. Layer on to these investment years that we're arguably near the apex of this capital markets cycle and any revenue gains from expanding into new areas could be offset by a cyclical downturn in the company's traditional businesses. While we see a material probability that the next two years may have flat to down earnings, we are fairly confident that the company will eventually be able to harvest its initiatives into higher returns on equity.

The company's first quarter was fine. Annualized return on tangible equity was 11.7%, and the company reported earnings per diluted share of $5.71. These were reasonable results given the slow start to the year for investment banks due to macroeconomic uncertainty.

Goldman's new management intends to increase disclosure of its plans over the next year, with a comprehensive strategic update by the first quarter of 2020. We imagine that the increased disclosure can only be positive for investors in the stock, as the company clarifies metrics for its new initiatives and sheds light on any areas that are underperforming, such as certain parts of its fixed-income trading operations. Transparency of meeting strategic milestones could also provide some relief if earnings fall with a cyclical downturn.

While consumer finance is competitive, the company's strategies are reasonable, so we have confidence that they'll be successful. Retail deposit funding, even if at online banking-type rates that are higher than deposits sourced from physical branches, should still be lower than the company's historical funding sources. Management is aiming to grow deposits $10 billion or more annually with a 100 basis-point improvement from its traditional funding sources. The digital bank is also likely to become a more comprehensive digital, retail platform with deposits, consumer lending, and investment management. Goldman Sachs has a much higher probability of success than financial technology startups with these initiatives, as it has brand recognition, can leverage existing capabilities from its other units (such as use products from its asset management unit in its wealth management unit or source loans from its institutional business for the bank), and has the ability to form enviable strategic partnerships, such as the recent Apple credit card.

For our analysis of recent developments in digital advice, please see our June 2018 special report, "Robo-Advisor Upgrade! Installing a Program for Profitability."
Underlying
Goldman Sachs Group Inc.

Goldman Sachs Group is a bank holding company and financial holding company. The company operates in four business segments: Investment Banking, which serves public and private sector clients and provides financial advisory services; Institutional Client Services, which serve its clients who come to the company to buy and sell financial products, raise funding and manage risk; Investing and Lending, which provides investing and lending activities across various asset classes, primarily debt securities and loans, public and private equity securities, and real estate; and Investment Management, which provides investment and wealth advisory services.

Provider
Morningstar
Morningstar

Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offer an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors.

Morningstar provides data on approximately 530,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries and had approximately $185 billion in assets under advisement and management as of June 30, 2016.

We have operations in 27 countries.

Analysts
Michael Wong

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